Saez and Piketty are really starting to annoy me now. They’ve been going around suggesting that the optimal top rate on federal income taxes is about 70%. Yet research recently published by Saez and Diamond makes the following points:

1. It’s very hard to close loopholes, so the optimal tax rate on capital should be calculated by taking those loopholes as a given.

2. If the income tax continues to have its current loopholes, the optimal top federal tax rate is 48%. BTW, under current law the top MTR is not 35%; it is considerably higher. However the tax code is so complex I can’t tell you the exact figure. I recall ObamaCare added another 3.8%, and there are some other quirks in the tax law that make the effective top MTR slightly higher. Certainly a top rate of 48% would be an increase, but less than many assume. (I could live with a 48% top MTR (or even more) if applied to consumption, not income.)

There is overwhelming theoretical and empirical evidence that higher MTRs sharply reduce work effort. Let’s review the evidence:

1. Theory. Because tax revenues are recycled back into the economy through various programs (mostly social spending in Europe) the income-compensated labor elasticity number is appropriate, which is unambiguously positive.

2. Evidence. Europe had tax rates close to US levels back in 1970, and a similar work effort. Then Europe decided to test the Prescott model by sharply raising taxes above US levels. A beautiful natural experiment, because we know that cultural differences would not explain any big differences in work effort. After all, the work effort was similar when the tax rates were similar.

3. More evidence. Then low and behold European work effort (in taxable market jobs) began falling sharply, so that before the current recession it was around 25% below US levels. This is what the Prescott theory would predict.

So you have both theory, cross-sectional, and time series evidence all strongly pointing to big government depressing work effort in Europe. And all competing explanations are rather ad hoc.

High taxes have depressed the labor supply in European economies, according to economist Edward C. Prescott, a Nobel laureate, who argues that Americans generally work more hours because U.S. tax rates are lower. The result: U.S. inflation-adjusted GDP per capita in 2010 was about 40 percent higher than the average for the euro area, according to data from the Organization for Economic Cooperation and Development in Paris.

‘This is Nonsense’

“This is nonsense,” said the Picketty, 40, a visiting professor at MIT in 2000-2001. “When people in Europe have five weeks of vacation, this is not in response to high tax rates.”

Oh really? I kept reading to learn why “this is nonsense.” And there was nothing . . . no explanation was offered. In the past I’ve noticed that some people have trouble with this idea because they think of work effort as being in some sense socially determined, not responding to incentives at the individual level. But these social policy decisions are be very much influenced by the average preferences of the public. So yes, a 35 hour work week and 5 weeks vacation may be government-determined, but ask yourself why government responded to pressure for these changes in France, but not in America. Obviously growth in government may not be the only factor, but it’s nonsense to claim that this explanation is “nonsense.”

HT: Dilip

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Glaeser/Alesina contend that unions in Europe have near-solved a massive social coordination problem. They do not put undue weight on his explanation, just its superiority to the alternatives of tax (Prescott) and culture.

(I could live with a 48% top MTR (or even more) if applied to consumption, not income.)

yes, a tax cut!

btw, my main issue with a lot of these studies is that they fail to treat the family as a unit: if one person works, but the husband/wife does not (but wants to) it does not necessarily make financial sense for him/her to go back to work due to taxes (among other things, like childcare). I know some families who are essentially paying for one person to work (negative revenue) but are doing it for non-monetary reasons like career development.

I agree that Piketty is far too dismissive of the possibility that tax rates are responsible for a nontrivial chunk of the differences in optimization along the the labor/leisure margin. But to be fair, Alesina, Glaeser, and Sacerdote have a paper arguing that tax rates are probably not the main culprit, or at least not provably so: http://www.economics.harvard.edu/pub/hier/2005/HIER2068.pdf

Prescott’s paper was never very convincing. It argued its case in, frankly, a very Prescott-like way: assume a utility specification that implies a Frisch elasticity overwhelmingly at odds with the evidence from empirical labor economics, then point to a few numbers and argue (sans econometrics) that the numbers seem to fit. (By the way, in my view Chetty et al. firmly rejected the usual Prescott/Rogerson/Hansen argument about macro elasticities in the most recent NBER Macro Annual: http://obs.rc.fas.harvard.edu/chetty/ext_margin.pdf )

I’m actually open to the possibility that long-term labor supply elasticities are significantly higher than short-term ones, because institutions need time to adjust, etc; there are a lot of effects that short-term natural experiments just can’t pick up. But the (inevitably fuzzy) empirical evidence on this story doesn’t amount to much.

One thing I don’t understand about Piketty, Saez, and Diamond’s argument for the optimal top marginal tax rate is that once you move away slightly from their model, the implication that we should push the rich to the top of the Laffer curve disappears. For instance, if you assume that the rich and poor are not simply providing different amounts of a homogenous labor input, but instead providing fundamentally different kinds of services with an imperfect degree of substitutability, then in general equilibrium the poor will bear part of the incidence of a tax on the rich. Near the peak of the Laffer curve, the benefit from additional taxation is second-order while the loss to the poor from this general equilibrium effect is first-order. At the very least, this indicates that the optimal top marginal tax should be somewhat lower.

(And the idea that the rich and poor tend to be providing imperfectly substitutable labor inputs is not some sort of wild economic heterodoxy; it is, for instance, fundamental to the whole skills-and-technology literature.)

“When people in Europe have five weeks of vacation, this is not in response to high tax rates.”
I’m french, and I can tell you if people don’t work more, it’s mainly not because of taxes, frankly it’s really stupid to think that, but because most people think they have enough money, even if they don’t earn a lot.
In my company we can make extra work sometimes paid twice more on sunday for example, and half of people are not interested, it’s always the same that agree to work more.
So far people who are ready to work more are young men, many man above 40 are not interested, they have enough money, and women prefers to spend time with they family.

So at the end of the day, the difference is cultural: “these social policy decisions are be very much influenced by the average preferences of the public.” The French wanted to work less and have more leisure, so they voted for policies that enabled these preferences.

We have also seen a flipping of leisure in the US so that wealthy citizens used to have more leisure, but now they have less. At the same time, tax rates on high incomes were reduced and the combination of higher low income support programs and higher payroll taxes has created much higher net marginal taxes on lower incomes.
Has there been any research on this? The leisure reversal seems like a huge cultural transition, and the possible tax implications seem strong.

Labor elasticity is an extremely complex subject, and I’ve always thought the very long run elasticities (which are hard to estimate) are much higher than short run elasticities. I think the cross sectional data is all we really have.

Also note that even if this article by Alesina, et al, is correct, it doesn’t help progressives like Krugman, who are very critical of right wing attacks on unions. Let’s say that the lower work effort (including a natural rate of unemployment that is much higher than Krugman would like) in Europe is jointly produced by unions and high tax rates. Then it would be completely accurate to say that the huge work gap, and real GDP gap, between Europe and the US is produced by progressive politics, broadly defined. Don’t hold your breath for American progressives to make that argument.

BTW, If I am “shooting from the hip” what is Piketty doing with an unsupported “nonsense” charge? At least I give reasons.

Matt, Good comment. I agree that long run elasticities are the key, which is why I only trust cross-sectional studies. BTW, the Asian data is also broadly consistent with the Prescott hypothesis, with Japan having more hours worked than Europe, and lower taxes, and Singapore having much higher hours worked than even America, and much lower taxes.

My other complaint is that this research (on top rate MTRs) assumes that higher taxes on Buffett would cause Buffett to reduce his consumption. That seems exceedingly unlikely in my view–but it gets us into the income vs consumption argument.

I agree with your final point, and indeed most of what you have to say.

kebko, Yup, I’ve made that argument several times. Think especially in terms of labor force participation by poor versus affluent women–there’s been a total reversal, roughly at the time the implicit MTRs reversed.

What I don’t get here is why a higher level of work effort is considered de facto desirable. Shouldn’t the measure be average standard of living? And from there, an equivalent standard of living at a lower overall level of effort would be the more desirable outcome. Trying to force more people into an already crowded labor market doesn’t benefit anyone unless you think that people would rather live in a household where everyone has to work full time to make ends meet vs one where only one person is required to work and even then gets to retain a significant amount of their time to invest in their own personal interests.

I’d like to see an MTR study that adequately splits out social benefits from high MTRs. i.e. Are Europeans working less because of high MTRs, or because they have a generous government pension and don’t have to save as much for retirement? My wife and I both work more because we have to save more, or else we’ll be living our retirement in a single-wide in Tornado Alley. (I’m not advocating high MTRs; I am with Dr. Sumner in pining after a progressive consumption tax).

Sure, Piketty is shooting from the hip even more. My point was simply that the clean natural experiment that you posited does not in fact exist.

The other bit to note is that Alesina/Glaeser are not just saying ‘it’s the unions who did it’. They’re also saying that ‘it’ is not just lower GDP, but also a higher social utility of leisure. They’re saying that Europe seems to have simply chosen a different point on the income/leisure trade-off, and that this was accomplished through progressive politics, broadly defined, as you call it (correctly).

Prescott’s/Ljunqvist’s analysis misses the point (made by Alesina/Glaeser) that productivity (GDP/hours worked) in Europe rose from 3/4ths that of the US (75% GDP at equal hours worked) to becoming almost equal (75% GDP at 75% hours worked).

“I could live with a 48% top MTR (or even more) if applied to consumption, not income”

I’m sure “you” could or other indiviudals and families who take in six figure salaries per year. What about people near the poverty line? How will they live with it as they consume all their income? The answer is very uncomfortably if at all. Yet you say that right now we have a shortfall of demand. Well a 48% or higher consumption tax rate will really help that.

As to all this talk about work effort I do think if it’s real it’s way overstated. According to you starting in the early 70s European countries raised their tax rates realtive to America. However, American’s tax rate at that time was at the S&D 70% optimal level that your arguing against here.

What’s clear is that the YS economy was booming during the Postwar era despite these supposdely effort sapping tax rates.

Overall it seems that according to you and other supply siders there is this terrible senstivity to taxes on the income side but none on the consumption side even though consumption taxes are borne much more by the poor-as they spend all their income on consumption. So there’s no worry about discouraging consumption.

Then again I believe you also like the wage tax idea-how will that not discourage work effort in the same way that income taxes are held to do-again in our own age of a 70% tax rate we did no tsee any drop in work effot.

Concetptually though this whole idea of work effort has always sounded wrong to me. Implicitly it only applies to the wealthy. It must. Someone who is poor or even lower middle class can’t “decide” that “you know, I think I’ll work less and take up the cello.”

Scott, working hours within Europe vary considerably. For example, hours worked per employed person in Austria per year are +/- 200 hours higher than hours worked in Germany. Similarly, the number in Belgium is 100 hours higher than in the Netherlands. This is the same difference as between the USA and Austria.

If the difference between the USA and Austria is due to tax rates, is the difference between Germany and Austria too due to tax rates? Similarly, Belgium & Netherlands?

I am less concerned with top tax rates, than with holding federal taxes to 18 percent of GDP, en route to lower percentages in the future.

If we got that federal-taxes-as-percent-of-GDP figure down to 15 percent, I would not mind if the bulk of that revenue came from gasoline and sin taxes, and whacking the rich through consumption taxes.

BTW, 18 percent is possible, with large cuts in Defense, Homeland Security and the VA, elimination of the USDA and rural subsidy programs, wiping out of Commerce and Labor, and raising the retirement age to 68, and encouraging humane euthanasia after age 80.

It would not even entail that much sacrifice, except for rural Americans, who largely would have to migrate to urban areas.

My other complaint is that this research (on top rate MTRs) assumes that higher taxes on Buffett would cause Buffett to reduce his consumption. That seems exceedingly unlikely in my view-but it gets us into the income vs consumption argument.

I agree. I hold that for those who own substantial assets, their consumption depends primarily on their capital, not their incomes. If their incomes are taxed more, then they will not consume less, they will just deplete their capitals, or reinvest less than they otherwise would going forward.

What wealthy person is going to say “Oh hey, my income tax just went up 10%, so that means I am going to cut back on my living standards by reducing the number of trips I make, or the number of cars I buy”?

Probably none. They’ll likely just make themselves $10 billion-aires rather than $10.1 billion-aires, and consume the same.

I’m confused by this statement “(I could live with a 48% top MTR (or even more) if applied to consumption, not income.)” Diamond and Saez are talking about the top MTR on labor income not Haig-Simons income. The standard result in the public finance literature is that labor income and consumption are equivalent bases under relatively modest assumptions. What are you getting at there?

Culture is endogenous, but so were the tax rate changes of the 1970s. The changes in taxes, regulation, and culture are all endogenous. I haven’t seen anyone point to clean identification. I’m agnostic about who’s right, but arguing exogenous tax changes caused changes in labor market regulation (as Scott appears to be doing) has omitted variable bias written all over it.

Scott wrote:
“I agree that long run elasticities are the key, which is why I only trust cross-sectional studies.”

I agree. If only Prescott had actually done one.

From Lars Ljungqvist (page 67)
“As emphasized by both Prescott (2002) and AGS, a critical assumption in Prescott’s analysis is that tax revenues are handed back to households either as transfers or as goods and services. This neutralizes the income effect of taxation and makes the substitution effect the predominant force, ensuring that a tax increase has the maximal negative effect on labor supply. The neutralization of the income effect means that the
consumption-to-output ratio is largely unaffected by tax increases”” what was earlier consumption bought by households out of their labor income is then financed with increased transfers from the government or replaced by government goods and services that yield the same utility to households as the foregone private consumption. Prescott’s (2004, equation 8) equilibrium expression for hours worked, reproduced
by AGS, reveals clearly the importance of the income effect being neutralized. If instead the government’s use of the extra tax revenues were not a perfect substitute for the crowded-out private expenditures, the consumption-to-output ratio would fall, and the expression shows how the substitution effect of the higher tax wedge would be undone. Given how important the consumption-to-output ratio is for the labor supply predictions, it is surprising that Prescott
does not discuss its contribution to the model’s success in explaining the American-European labor market divide.”
(From Scott’s link on 1. May 2012 at 08:04)

Actually, given Prescott’s determination to prove his agenda come hell or high water, I’m not at all surprised.

Here’s what Prescott had to say about this assumption in 2002:
“The assumption that the tax revenues are
given back to households either as transfers or
as goods and services matters. If these revenues
are used for some public good or are squandered,
private consumption will fall, and the tax
wedge will have little consequence for labor
supply.5 If, as I assume, it is used to finance
substitutes for private consumption, such as
highways, public schools, health care, parks,
and police protection, then the ct/wt factor
will not change when the intratemporal tax
factor changes. In this case, changes in this
tax factor will have large consequences for
labor supply.”

In other words, labor supply is highly elastic because, well, er, em, we assume it is.

So what does Prescott do next? After constructing his model, he applies it to seven nations over two time periods using the estimated parameters (that’s a total of 14 data points folks).

Then he notes two wildly off mark estimates (Italy’s actual labor supply in the early 1970s was less by about a third, and Japan’s by about about a quarter) and explains them away by some anecdotal hand waving.

Having tuckered himself out by all this empiricism he more or less declares victory and calls it a day failing to note that at least half the reason his model more or less fit the data in the remaining 12 observations was that the consumption to output ratios rose in all of these countries despite the fact that the effective marginal tax rates also rose in all but one. (Ljungvist fortunately does a decomposition.)

The fact that the consumption to output ratios uniformly rose despite near uniformity of increases in MERs would seem intuitively to be the opposite of what his model simplies. As he notes on page 5 (2004):

“The c/y term captures intertemporal
factors. If, for example, the effective tax rate on labor
income is expected to be higher in the future, people
will choose a lower current value for c/y, and current
labor supply will be higher.”

In short, if it isn’t clear, I don’t take Prescott’s paper too seriously (based on the amount of effort he put into it neither did he). I’m much more inclined to believe that labor supply is a function of other institutions (labor unions, regulations, benefits, culture etc.).

P.S. Of the five nations that had higher effective marginal tax rates than the U.S. in the early 1970s in Prescott’s paper, all but one (Italy) had a higher actual labor supply. This would seem to imply other factors are at least as, if not more, important.

Having tuckered himself out by all this empiricism he more or less declares victory and calls it a day failing to note that at least half the reason his model more or less fit the data in the remaining 12 observations was that the consumption to output ratios rose in all of these countries despite the fact that the effective marginal tax rates also rose in all but one.

Your conclusion is not confirmed by that data, for another conclusion, call it B, is that the remaining 12 observations would have otherwise have shown an even higher consumption to output ratio, had the effective marginal tax rates been lower. This conclusion B is also perfectly consistent with the data.

You can’t reject B and accept your conclusion on the basis of the data. You have to compare your conclusion and conclusion B to each other by way of economic reasoning.

Alex I was speaking about people near the poverty line yes. I didn’t say they would face the MTR. What I did say was they would be hit much harder by Sumner’s preference for a consumption tax of 48% or higher.

My point is he opposes say a 48% MTR as he says it will hurt incetnive and yet supports ths same thing on consumption-those near the poverty line spend all their income on consumption. Right now he agrees that the problem is lack of demand yet seems not consider that such a high rate of tax on consumption would discourage consumtption.

He also likes the wage tax and yet seems to think that this will do nothing to hurt work incentive.

Mark A. Sadowski, I find it hard to blame Prescott for not addressing income effects, because income/distribution effects are very hard to reason about. It’s even hard to make a rigorous case for which way the effects will go, since this depends on fine details about the agents’ endowments, technology and the like.

There was no statistically significant change to US hours worked from 1970 to 2011 despite 1980s and 2000s tax cuts and 1990s tax increases. (If you don’t suppress your pattern recognizing brain, you’d even say there was the opposite response … more hours worked when taxes were higher.)

There was no statistically significant change from the trend to the hours worked in France since 1970 even when they adopted the 35 hour work week in 2000.

I did manage to see a statistically significant variation in hours worked in the Netherlands in 1986-1987, but there doesn’t seem to be any policy associated; hours worked seem to fall suddenly by 4 weeks (!) despite tax cuts/budget cuts and a deregulation and liberalization agenda. [Probably a data error and not a real effect.]

There do not seem to be *any* statistically significant responses to policy changes in number of hours worked per year since 1970 in any of the countries in the FRED database — just long term trends.

Now I do understand that your theory is that high MTRs likely make it easier to (politically) coordinate a shorter work week, but shouldn’t there be a stronger response to policy changes? If there is no response to changes in the MTRs how are people coordinating? If there is no response to vacation and work week mandates, why are they coordinating?

People spend a lot more time at dinner in many European countries (you generally get the table for the whole night). Is this because Americans are more eager to get back to work because of lower MTRs?

My guess is that some effect similar to a potential mechanism affecting savings could be present. People want to save a certain amount, so lowering taxes on savings or boosting returns *reduces* the amount of money people save. Likewise people want to work a certain amount, so reducing taxes could make them work less at the same job. MTR changes could affect decisions to take on new jobs (MTRs alter perception of marginal work changes, but not work level). The net effect is a wash.

The debate on taxes misses a bigger point. The burden of the government on the private sector is spending since spending is higher than tax revenues. All the resources the government spends (or taxes if they are running a surplus) come at the expense of alternative uses in the private sector, the area that really drives economic progress.

On the tax debate, the argument that higher taxes should encourage people people to work more to make up the difference are like an argument that we should destroy things so that people have to work harder to rebuild them. The point is that economic well-being isn’t just measured in terms of work hours or incomes. Economic well-being comes from individuals being allowed to use their time and money how they best see fit. The fact that people have to put in much less work time to create food and shelter and have more time for leisure is a sign of progress.

Major Freedom wrote:
“You said he failed to note the part I quoted you as saying. That argument you made is what I responded to, not what Prescott said.”

I’m not the only one who is pointing this out. I’ll quote again:

“Given how important the consumption-to-output ratio is for the labor supply predictions, it is surprising that Prescott does not discuss its contribution to the model’s success in explaining the American-European labor market divide.”
– Ljungqvist (page 67)

And:
“This comment tells me that you are very much interested in fitting data to fit your preconceived conclusions.”

So based on my implicit accusation that Prescott is ideologically biased you’re willing to imply the same of me. Spoken like a true ideologue.

Mark A. Sadowski, I’m not sure about that. Consider a world where all revenue from income taxes is somehow distributed to those agents who have low income-elasticity for consumption and high income-elasticity for leisure. Then the income effect from labor taxation makes labor supply more elastic rather than less so. One could argue that the real world does not look like this, but it’s very hard to make that kind of case in a rigorous way. It’s easier to assume that distributional effects are zero and leave it at that.

“You said he failed to note the part I quoted you as saying. That argument you made is what I responded to, not what Prescott said.”

I’m not the only one who is pointing this out. I’ll quote again:

“Given how important the consumption-to-output ratio is for the labor supply predictions, it is surprising that Prescott does not discuss its contribution to the model’s success in explaining the American-European labor market divide.”- Ljungqvist (page 67)

So your maxim is that whenever someone else says the same thing you do, that absolves you from properly justifying what you say?

Maybe if I was having a beer with Ljungqvist, I’d bring it up, but you’re presenting this as your argument, so you have the responsibility to justify it.

And:

“This comment tells me that you are very much interested in fitting data to fit your preconceived conclusions.”

So based on my implicit accusation that Prescott is ideologically biased you’re willing to imply the same of me. Spoken like a true ideologue.

Based on your now explicit accusation that I am ideologically biased, it tells me even more that you are very much ideologically biased.

You accused Prescott, and now you accused me, of being ideologically biased, solely because our conclusions disagree. In my experience, that tells me you are ideologically biased.

It is like a theist reading the conclusion of an evolutionary biologist, and then trying to infer which God the biologist used to get to his conclusion, since after all, all conclusions use God as a means, right?

anon,
One can create models that produce all sorts of outcomes. The point is that Prescott’s equilibrium expression for hours worked (equation eight in his 2004 paper, which unfortunately got a sunglassed smiley face in my initial comment) produces an elastic labor supply simply by assuming a constant consumption to income ratio. It’s sort of like the old joke about the economist who assumes a can opener.

I think it’s more important to empirically determine what the macro elasticities actually are, which Prescott certainly hasn’t done.

1) Whether a tax increase causes an increase or decrease in hours worked depends on the marginal utilities of income and labor. A knee in the income utility curve will cause someone to work up to the knee. If you have $500 a month rent to pay, you have to work enough hours to earn $500, even if you’d prefer to work less.

2) The Germans seem to have gotten work sharing to work, but their history of labor relations and government involvement in pensions and healthcare has a long history. The model may not be easily exportable without the necessary cultural background.

3) The important point, at the moment, isn’t whether taxes explain the differences, but rather whether the model is sustainable.

a) There’s a contagious sovereign debt crisis.

b) There’s an equally bad consumer debt crisis.

c) The major banks are insolvent and on ECB life support of over 1 trillion euros.

d) The ECB balance sheet is over 3 trillion euros, which at around $4 trillion is substantially more than the Fed, and there’s a demonstrable need for around 2 trillion euros more.

e) The Greek bailout plan projections are a sick joke, and nobody has a plan for what to do when it fails in a year or so.

Major Freedom,
Let me summarize. Prescott intially assumes constant consumption to income ratios to get an elastic labor supply. He later predicts lower consumption to income ratios in response to higher marginal effective tax rates. Yet his (highly limited) data set shows nearly universally the opposite pattern. And, finally, he ignores the changes in the consumption to income ratio when discussing the semi-fit of his model to some of the data. Thus, I do not find his paper particularily convincing.

If you finally got your wish and the Fed started to target 5% NGDP level targeting, and it just so happened to require 20% price inflation (I distinctly recall you said you will support 5% NGDP with 20% inflation or -20% deflation, you don’t care), and this price inflation led to rioting/protesting, somewhere in the country, from those whose incomes don’t rise but the prices they pay for do rise, and this riot resulted in just a single shooting death, would you in any way feel intellectually responsible for it?

Peter N,
That’s just the thing. Everyone is talking about the house next door which is on fire, but right now we are talking in different languages – as if we were all cranks! It is almost as if the solution lies through a ‘wormhole’ to the next universe.

I haven’t seen any interesting answers from him there, however,
Brad Delong asked him this question:

As you know, Paul, ever since I decided to force my 700 Econ 1 students to read Milton and Rose Director Friedman’s “Free to Choose”, I have been trying to understand why those who claim to be Friedman’s intellectual disciples–especially those who hold appointments at the Becker-Friedman Institute–have not been aggressively out there condemning Bush, Bernanke, and Obama for insufficient policy activism. The natural generalization of virtually all of Friedman’s work to the current situation is that the task of the government is to Stabilize the Growth Path of Nominal GDP by Any Means Necessary–which means issuing cash and buying stuff that is not a perfect substitute for cash with it until nominal GDP is on its previous growth path.
Yet the ranks of Friedman disciples appear to be limited to Scott Sumner and (perhaps) David Glasner.
And in this morning’s FT I read my guru Martin Wolf writing about how for central banks “The immediate task is to manage an exit from the interventions.” He does go on to say that “A far greater danger exists of premature retrenchment than of excessive delay…” but the initial sound bit makes me wince. And his colleague the highly-intelligent and usually reliable Gideon Rachman denounces you for shrillness and warns us that “the assumption of unlimited Dutch and German creditworthiness” to support fiscal expansion “is unconvincing”.
It seems to me that we have lost not just those professional Ph.D. economists who became addicted to DSGE and RBC models and lost touch with reality, but have also lost a good many who either want to retain contact with reality or who ought to be willing to worship Milton Friedman as their guru. And I am still not sure why, or how…
Yours,
Brad DeLong

If you actually mean against their will I think any person who is not wholly a moral dengenerate would have to say they’ll pay the nine cents-assuming your numbers are right-how do I know where you got them from.

This shows how far the desire to save a few dollars in taxes goes I guess. Don’t mind me I find that an amusing position is all. I wonder if you’re also “pro-life.”

Don’t get me wrong I’m all for euthanasia if it’s the choice of the individual-the one problem with it of course is that it’s not always easy to be sure in some cases-that was the whole Terry Schavio wing ding that was being debated for months.

But to tell someone who’s 80 they should “do the honorable thiing” well if you mean that seriously you’re getting overly economicstic.

I think economically enough to realize that a certain level of basica humanitarianism is itself economically and socially optimal.

And to think Benjamin that the tea party came to power by telling everyone Obama was going to institute death panels. Are we now talking about the real thing? Yet you’re not a Democrat? Don’t know what to think as Rush assures us all moral degenrates are Democrats.

The cause of the problem is clear enough. A monetary union between economies with such different cultures and levels of economic development without any means to apply localized economic remedies is crazy.

Talking about the moral failures of the debtors with no regard for the moral hazard of the creditors is also not a very enlightened view in economic terms. What’s so special about these creditors that they should be protected from risks other investors are expected to accept?

As with the GSEs in this country, people would have thought twice about lending money on those terms if they didn’t believe there was an implicit government guarantee – by the US treasury in the one case, and the eurozone and the ECB in the other.

The solution is clear enough – forgiveness of debt. If the creditor won’t forgive and the borrower can’t pay, it’s unlikely that debtors’ prison is the answer. The English tried it for a few hundred years (cf. Little Dorrit).

The result is an impasse that only the creditors can break. Unfortunately, the creditors are themselves debtors to others and effectively insolvent. In fact it’s approaching the point where everybody is insolvent. Governments always are and have for a long time been inherently insolvent.

If you’re not happy taking your $20 federal reserve note to the Fed and getting a brand new federal reserve note in exchange – well, nobody can take from you your right to be unhappy.

It’s Tinkerbell money, without the belief of the audience, it’s just paper. If people believe that a government’s future revenues won’t cover its liabilities, then that government will never get a chance to prove otherwise. If it can’t devalue, the speculators will pick its bones clean.

Now if you entangle a bunch of governments so they sink or swim together, and they all sit around arguing whose turn it is to swim and whose fault it is that they’re sinking, it doesn’t look to end well.

The nature of these sorts of crises is that the longer you let them fester, the more they cost to fix. This could have been fixed for cheap two years ago(temporarily, anyway. The euro would still have been doomed long term.).

I fear that if a serious speculative attack on the ECB were to start (say after they’ve added one or two trillion more euros of toxic waste to their balance sheet), it would get really ugly. If the Germans pulled out of the euro, the rump ECB would be toast.

I always wonder how state and other taxes affect this. My marginal income tax rate (California) is already above 50% and will soon be above 55% I believe. My overall tax rate is already about 45%. So, what room to increase?

Scott — Thanks for doing this post. I too have been following the SP and D advocacy of a return to statospheric MTRs and am taken back by the loaded language they use, which connotes a left wing ideology rather than an economic argument. For example, in that Bloomberg piece, Piketty uses the term ‘extract’ to characterize the income share of top earners. S and D have used terms such as ‘capture’. This connotes the idea that income is simply given (zero sum) and thus simply waiting for bleeding heart econometric model to divide it up much more fairly. And, of course, some of these models assume a closed economy, no labor or capital mobility and no overwhelming pressure to litter the tax code with even more loopholes when rates shoot into orbit. In other words, assume a fantasy world which does not exist.

Peter N,
I certainly agree that people need local economic responsibility, in order for monetary policy to work between countries. Not to rule out the possibility of debt forgiveness, but a lot of mutual understanding would have to transpire first. Most importantly, we are still holding all those promises and contracts between governments and citizens that happened in the twentieth century. They played out the way they did because, for decades, it seemed possible that they actually could. But we can’t expect real assets and goods to be able to fund the needs of human services much longer, and we need to find out how to recreate that wealth while the present generations are still able to adjust to such changes. Otherwise, a lot of human skill and knowledge could be lost. To be sure, it feels lousy for creditors to leave buildings empty because they can’t, or won’t, employ new purposes for them. But my main concern is that people with debts impossible to pay at least have a soft landing and the encouragement from the public that they will not just be left out in the cold.

In other words I do not know if we will get forgiveness of debt. But if we try, we can get forgiveness for people, forgiveness which also means finding ways to put their hard won knowledge to good use, even if not through monetary means.

Let me summarize. Prescott intially assumes constant consumption to income ratios to get an elastic labor supply. He later predicts lower consumption to income ratios in response to higher marginal effective tax rates. Yet his (highly limited) data set shows nearly universally the opposite pattern. And, finally, he ignores the changes in the consumption to income ratio when discussing the semi-fit of his model to some of the data. Thus, I do not find his paper particularily convincing.

Yes, I understand this particular argument, but I was asking about this argument you made:

“Having tuckered himself out by all this empiricism he more or less declares victory and calls it a day failing to note that at least half the reason his model more or less fit the data in the remaining 12 observations was that the consumption to output ratios rose in all of these countries despite the fact that the effective marginal tax rates also rose in all but one. (Ljungvist fortunately does a decomposition.)”

Out of curiosity, how much of these tax theories take the stance of monetary policy into account? Does it matter if the CB is targeting inflation, NGDP level, or some other variable that might influence the outcome or even change our opinions about which theories seem rational? The various ways we arrange money at the very top level seems to change certain rules that appeared on the surface like physics of economics, only to bump against a reality of them being mere reliable side-effects of a particular management process that is taken for granted and we don’t notice until things change.

For example, I don’t support a progressive income tax or even the theory behind it, unless the quantity of money is constrained, and we get stuck in a monetary girdle of no/very slow growth with all of the other ugly effects that come with it that impact hours worked, employment levels etc… If we cannot get the societal benefit from stable and mild inflation, an investment oriented economy, and everyone turns into mattress stuffers expecting to profit from hoarding, then by all means we should resort to other measures even if they seem a bit draconian – because the name of the game changes decidedly at the point that there is no growth to maximize.

I don’t really like the idea of redeeming the very ideological principles I’ve stood against for many years because I saw them as a duplication of effort that resulted in unintended consequences all their own, but there are certain trade offs when tossing Friedman and Reagan under the inflation chicken little bus, accepting money as wealth and arranging policy in that manner. If we can’t foster a society of self-sufficiency with plentiful opportunity for people who are willing to work hard, and maximize purchasing power with supply-side efforts then I do not know what there is left for all the unfortunate people who truly do get left behind; which in the monetary arrangement we currently have, we are making those people as a matter of policy. If we want to profit from hoarding, then we should have the trade off of higher direct taxation based on something other than income. If we are asking society to sacrifice an ever larger group of random members to be hopless in order for the government to guarantee wealth in money, then there ought to be the realization that the gain from it is not free, and there should not be the expectation of retention of any large portion of it so we can compensate these people for a lifetime of damages.

“It’s dangerous to equivocate morality and economics. In many languages debt and sin have common roots, but there’s little profit in thinking this way.

Forgiveness of debt isn’t a moral issue, it’s more like cleaning out a plugged drain before you drown in sewage. Markets have to to clear.”

The etymology of the term “moral hazard” is not entirely clear and it is less clear that the term has anything to do with “morality” as we now know it. The term was first used extensively by English insurance companies in the 17th and 18th centuries.

Nevertheless, I’m pretty sure that if I clean out my drain it is not then more likely to clog in the future. Can we say the same about forgiveness of indebtedness?

You are always very unhappy with taxes on capital, but it seems to me you are assuming that tax incidence is on the capital owner. That doesn’t sound right to me. If capital is a scarce resource, capital tax will most likely fall on the user of capital. It’s best understood on loans. Surely the interest itself incorporates the compensation for the taxes paid by the lender on the interest. You can see equity as a loan with infinite maturity and a variable coupon.

If the incidence really fell on the lender, the only possible explanation would be that capital is not scarce and that it’s accumulation would not really improve the economy potential that much.

There are practical reasons for using the same tax rate for wage and capital income (since it’s possible to transform one in the other in many professions, creating an economic distortion). If the incidence acts as I outlined, the argument against taxes on capital income is weakened.

I would personally set corporation rates at the maximum personal rate, giving people the ability to claim both income and tax paid on their own taxes (piercing the veil so to speak). Dividend would not be taxed (as they are just a transfer in this case). I would still allow income deferral in a special trust (up to some generous but not unlimited amount, maybe 100 times average annual wage), both for retirement and for people who have erratic income streams (as they are unfairly taxed at a higher rate). Withdrawal from the fund would be counted as income for the year.

On “When people in Europe have five weeks of vacation, this is not in response to high tax rates.”

In the late 1970s, Modigliani dismissed the 1969 Lucas-Rapping paper on the U.S. great depression as the great vacation theory of depressions where the voluntary unemployment of the 1930s is explained, in Modigliani words, as a “congenital attack of laziness”.

An increased preference for leisure is another name for voluntary unemployment.

As Prescott pointed out in papers in 2002, 2004 and 1999, the USA in the Great Depression and France since the 1970s were both 30% drops in hours worked per adult. That is why Prescott refers to France’s economy as depressed.

Others such as Blanchard and now Piketty respond attribute lower labour supply in the EU to their greater preference for leisure

An unusual left-right unity ticket has emerged to explain depressions in the 1930s and the depressed EU economies after the 1970s: the great vacation theory.

In reality, time use studies conclude that lower hours of market work in Europe is entirely offset by higher hours of home production, implying that Europeans do not enjoy more leisure than Americans despite the widespread impression that they do.

“Nevertheless, I’m pretty sure that if I clean out my drain it is not then more likely to clog in the future. Can we say the same about forgiveness of indebtedness?”

Since without a working drain, you’d have to move out, a re-clog would seem to be a secondary consideration. Would you really refuse to let the plumber clear it unless you had a no re-clog guarantee first?

“Unless 20 years from now, all Southern States in Europe have made like Southern States in US. They have cut regulations, supported right to work, crushed unions, and won real jobs.”

You are somewhat filtered here in your recollections… Southern states also receive massive federal tax transfers from wealthier states – those transfers are not feasible in the EU. I am not at all confident that, without those transfers, the South would have risen so fast…

Peter N,
Only a few posts back I tried to explain that I don’t like to bring morality to economics. I simply meant that debt forgiveness needs to be understood in terms of what could actually be accomplished before it is considered. The burdens so many countries now carry are the result of long term structural imbalances (in production capture) that are not yet well understood, hence could easily return almost as soon as they were wiped out. In the present we are not utilizing knowledge and skills as directly as we need to be, and that is the primariy cause of our imbalances. That’s the puzzle we have to solve before debt forgiveness could actually work. Plus, it is why I can not at all take seriously the proposals to increase taxes in the present, as it has become impossible for them to fulfill the purposes people imagine they might achieve. While those taxes are but a drop in any government’s bucket that does practically nothing in meaningful terms, they are a real loss to the person who gives the taxes up.

“Since without a working drain, you’d have to move out, a re-clog would seem to be a secondary consideration. Would you really refuse to let the plumber clear it unless you had a no re-clog guarantee first?”

That’s a cleverly evasive non-answer. You’ve set up the flawed analogy in the first place, but what makes you think that clearing the markets requires debt forgiveness? There are other alternatives—just not the ones you seem to favor. You seem to admit that moral hazard is a consideration with respect to debt forgiveness, albeit a secondary one, but who said moral hazard is always a primary consideration? And, you can’t seem to come up with a reason that it would be a consideration at all with respect to clearing a drain. You may not like the consequences of not clearing your sewer drain, but that has nothing to do with the economic theory of moral hazard. I could, however, change the facts somewhat to make the analogy more relevant: Let’s suppose someone threw something into your drain they were not supposed to (use your imagination here) that caused it to clog. You might then call the plumber, but wouldn’t you also be tempted to hold that person somewhat responsible so that it is less likely to happen again? Moral hazard has nothing to do with “guarantees”.

“You are somewhat filtered here in your recollections… Southern states also receive massive federal tax transfers from wealthier states – those transfers are not feasible in the EU. I am not at all confident that, without those transfers, the South would have risen so fast.”

Stats, I don’t think it won’t be more painful, I just know that pain is good.

1. Smaller States are beneficiaries ONLY because liberals in blue states have been forced to buy off small state compliance.

2. I’m a giant advocate for blue states keeping their own money. I think this could be hastened by say the ending of Obamacare.

This can happen almost invisibly. We move Medicaid and Medicare to block transfers. We say we are doing it based on cost of living, so small rural states get less money per patient. So we role back minimum level requirements.

Very quickly the rich states gets an influx of freeloaders. Forcing rich states to become more stingy or to become poor states.

Meanwhile in this new Federalist world states are fast competing, not just to keep taxes low but adopting the policies (highly productive public employees) of their betters.

“But what makes you think that clearing the markets requires debt forgiveness?”

Mathematics and history. This is Kenneth Rogoff on the subject:

“But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation.”

Willem Buiter:

“But all other creditors, be they private or official, including the ECB, the bilateral Euro Area creditor governments, and anybody else that may in the future be contributing to Greece, better recognize that Greece is not capable of servicing the debts. Just write it off. That still leaves a funding gap for the Greek sovereign, depending on your estimate, there still is a primary deficit, a non interest deficit for the general government of between two and four percent at least. So that still would have to be funded. They have to continue funding that, but no more.

And then, really, leave it up to the Greeks to reform themselves. There’s no way that we’re going to be able to turn Greece into a colony of Brussels, Frankfurt, and Washington, and run it as a vassal kingdom for the next eight years.”

“Write off the public debt, recapitalize their banks, using European resources, obviously, because there aren’t any Greek resources. Keep them in the Eurozone, very definitely. It’s both in the Greek interest and in our interest. Then provide further minimal financial support. Don’t build up another debt burden, but sufficient to run steadily diminishing non interest deficit for the general government and ultimately have that peter out and turn the country into a country with a sizable primary surplus, but not from a position where they spend six or seven percent of GDP on interest. So write off the debt, restructure the banks and then make conditional funding, of the kind that is now available, forthcoming.

But don’t get on the self righteous high horses that are ridden by so many European politicians, especially from Germany and my own home country, the Netherlands. It is, I think, offensive. It forgets that there cannot be a reckless debtor without that reckless debtor being accommodated by a reckless creditor.

The Dutch and the Germans savers and greedy investors are as culpable of the financial mess that we’ve created in Europe as the debtor countries. It takes two to tango here. When you don’t know what to do, shut up. I think that would be the best advice I can give to our politicians.”

George Soros:

“…he heavily indebted countries are now at a severe disadvantage, because they have basically become heavily indebted in a foreign currency, in the Euro. They do not control it, and so they are in the same position as third world countries in Latin America were in at the beginning of the 1980s – a situation which led to a lost decade there. Europe now faces a lost decade. The situation in the European Union, though, is much worse than it was in Latin America, because the European Union is a political union. The political tensions over the Euro could eventually destroy the EU.”

” Let’s suppose someone threw something into your drain they were not supposed to (use your imagination here) that caused it to clog. You might then call the plumber, but wouldn’t you also be tempted to hold that person somewhat responsible so that it is less likely to happen again? Moral hazard has nothing to do with “guarantees”.”

I think this is a fine hypothetical. Prevention of moral hazard is a guarantee of proper assignment of risk like evolution is a guarantee of fitness (which is to say it isn’t). What’s guaranteed is that there are no incentives to misassign risk.

The question is, though – will you wait to call the plumber until blame has been correctly placed and acknowledged – will you hold an inquiry and auto da fe while knee deep in sewage?

“‘But what makes you think that clearing the markets requires debt forgiveness?’

There is nothing in what follows involving history, mathematics (or logic) that requires “debt forgiveness”. And, more to the original point, none of the persons you are citing as historical or mathematical “proof” would argue that, even if “debt forgiveness” were an appropriate policy prescription, it does not involve “moral hazard”.

Let’s take Rogoff, who qualifies as an economic historian, but please, George Soros?. Nothing Rogoff has written argues that “debt forgiveness” is a necessary consequence of the current crisis. If we concentrate of sovereign indebtedness within the EU (let’s say Greece), the mere prospect of “debt forgiveness” has likely prolonged the crisis–not shortened it. Here, however, we have a term that begs definition—“debt forgiveness”. You’ve written:

“The solution is clear enough – forgiveness of debt. If the creditor won’t forgive and the borrower can’t pay, it’s unlikely that debtors’ prison is the answer. The English tried it for a few hundred years (cf. Little Dorrit).

The result is an impasse that only the creditors can break. Unfortunately, the creditors are themselves debtors to others and effectively insolvent. In fact it’s approaching the point where everybody is insolvent. Governments always are and have for a long time been inherently insolvent.”

The “solution” as referenced above is not at all clear. Who is to forgive whom—and how? Debtor’s prisons do not exist for sovereign governments. The best solution, and one of which Rogoff has cited (but did not necessarily endorse any more than “debt forgiveness” ) is *default*. One could argue, but I trust this is not what you had in mind, that default is itself a form of “debt forgiveness”. I say this is not what you hand in mind, because it is certainly not “an impasse that only creditors can break”. Default is the quickest method of “clearing the drain”; it generally assigns losses where they should be assigned, and does not entail the same risk of “moral hazard” as would other forms of voluntary “debt forgiveness” that you presumably had in mind. Had Greece been allowed to simply default (rather than go through the tortured and lengthy process of technical default through partial “debt forgiveness”), had GM been required to go through normal bankruptcy proceedings, had homeowners not been bailed out by various government programs, etc., the financial crisis would likely be closer to being over than it now is and, more importantly, there would be less chance of a repeat performance.

As far as “assigning blame” through default, there is really no need to do so (even though I think we pretty much know who the culprits are). The markets and bankruptcy courts will deal with that if only we would let them.

If there were also a decrease in unemployment and the suicide rate went down, could Scott take credit for the lives he saved?

Of course. But then you’d have to take into account those who killed themselves within the group of tens of millions who went unemployed because of past inflation, which Sumner can take partial intellectual credit for.

ChacoKevy, Why even link to that silly post? It’s not a 3.8% sales tax, it’s a 3.8% income tax.

KRG, I want people to freely choose how much to work, without government distortions. Krugman and I think 9% unemployment is a tragedy. Others seem fine with it.

Sam, Social benefits are the same as higher MTRs. Indeed the poorest often face the highest MTRs.

Ritwik, I doubt the millions of unemployed in Europe are enjoying their leisure. The equality of productivity between Europe and the US is of course very misleading, because the US labor market has many more low skilled workers, because of our weaker labor regs and higher immigration. The productivity of any given worker is higher here–you have composition bias.

Mike Sax, You said;

“”I could live with a 48% top MTR (or even more) if applied to consumption, not income”
I’m sure “you” could or other indiviudals and families who take in six figure salaries per year. What about people near the poverty line?”

How many people near the poverty line are in the top tax bracket? And consumption versus income taxes have no bearing on the AD issue.

Martin, I have no idea.

Anonymous, I’m in a similar situation (although I don’t recall my exact federal MTR.) But I’m considered much “richer” because my wife and I are married. If we were living in sin Obama wouldn’t consider us rich.

MF, I agree.

John, I agree that labor and consumption taxes are identical. But Saez also favors taxes on capital. I’m opposed. In addition, Saez favors income taxes and I favor payroll taxes only, with the 1040 form being abolished.

Charlie, Sure it’s complicated. But consider this. For years conservatives have been arguing that high MTRs and unions reduce employment. Liberals scoff. When a study shows that high taxes appear to reduce employment, liberals trumpet a study saying “no, to was unions.” Isn’t that a bit odd? Or they say “unemployment isn’t so bad after all, it’s “leisure”,” after mocking conservatives for making the same argument.

Mark, Yes, but I believe revenue neutral is the right assumption. The extra revenue collected in Europe as compared to the US is almost all given back in social welfare programs. BTW, saying it’s wasted isn’t much of a defense for big government, is it? Prescott’s making the most generous assumption for the socialists.

Regarding your PS, Italy was much poorer than the US in the 1970s, so that’s part of it. And are the Italian hours accurate?

Jason. Taxes as a share of GDP in the US didn’t change significantly between 1970 and 2011

Saturos, Actually Kling said they could, but the result would be high inflation. He’s skeptical it would help RGDP very much.

Peter N. You said;

“It’s fine to talk about the advantages of the Fed targeting NGDP, but meanwhile, the house next door is on fire.
What should we be doing about that?”

Targeting NGDP would prevent our house from catching fire, and it would reduce flames on the house next door.

MF, You said;

If you finally got your wish and the Fed started to target 5% NGDP level targeting, and it just so happened to require 20% price inflation (I distinctly recall you said you will support 5% NGDP with 20% inflation or -20% deflation, you don’t care), and this price inflation led to rioting/protesting, somewhere in the country, from those whose incomes don’t rise but the prices they pay for do rise, and this riot resulted in just a single shooting death, would you in any way feel intellectually responsible for it?”

I’d sleep soundly at night knowing that w/o NGDP targeting there would have been bigger riots with more shooting deaths. Isn’t it your austerian philosophy that should lead to sleepless nights.

Asco, Should I know what “reddit” is?

Statsguy, Yes, there are many corrupt and/or stupid people in the world–that’s what we are trying to change. If we don’t change it, we will certainly lose.

Tommy, Good point. Some wealth is extracted, but most isn’t.

A Carraro, No, I’m not assuming the owners bear the burden of the tax, just the opposite.

Jim Rose, Very good point. I made a similar point in a comment above.

Steve Roth, I’m afraid you are in error. It’s standard to assume only a substitution effect in aggregate tax analysis–where does the tax money go? Surely not down the drain? If it did, that would be even worse for the European system.

“How many people near the poverty line are in the top tax bracket? And consumption versus income taxes have no bearing on the AD issue.”

I guess I missed the part where you said a MTR on consumption-I naturally connect a MTR with income. Currenlty at least there are no marginal rates on most consumption. We all pay the same sales tax rate regardless of income level.

The reason consumption vs income taxes has a bearing on demand is that if you impose a high consumption tax that hits people nearer the poverty line who account for a large part of AD in their general consumption. Again currently there are no marginal rates on consumption. I go to the grocery store here in NY I pay the same tax on a loaf of bread as you do regardless of our respective incomes.

I’m guessing what you have in mind is some sort of subsidy to people below a certain level of income like Gingrich claims he’s for. My guess is that the poor or lower middle class won’t end up better in this scenario. I still am waiting to see the day when a Republican congressman actually writes that bill for a wage subsidy. My guess it the sales tax would happen but there;d be no subsidy. After all we are currently hearing all the complaining about those “near 50% of Americans who pay no tax” which is a total lie anyway. They ignore the regressive payroll tax and the state income and consumption tax.

What this reminds me of is a place like Latvia which until recently at least-may still do I don’t know-had something like a 60% wage tax with no subsidy.

This whole move to go from income taxes to consumption and wages is both demand cutting-as 70% of econoic activity is driving by consumption-as well regressive.

Why income taxes somehow discourage work and not a wage or conumtpion tax I don’t know those I’ve heard this argument for years. And I’m still waiting for you to explain to me why during the postwar years we had the 70% rate you are decrying here and yet the economy boomed. whatever disincentive we had didn’t mattter very much.

In any case as the rich consume a much smaller part of their income, clearly a 48% tax on their consumptoion rather than their income is going to effectively be a major tax cut for them. This drop in revenue will require other tax hikes somewhere else-which is what Herman Cain wanted with his national sales tax-or draconian cuts in public spending-Ryan’s privaitzation scheme for Medicare what am I saying I mean “block grants”, “fixing social security” by ending it, etc. My guess is that in reality it would take us to both places-the tax cuts on the wealthy will be paid for by increased taxes on everyone else and deep cuts in Medicare, Social Security, etc.

“KRG, I want people to freely choose how much to work, without government distortions. Krugman and I think 9% unemployment is a tragedy. Others seem fine with it.”

Indeed- the question is how to bring that 9% down; freely choosing how much to work should involve allowing some portion of that 9% to freely choose to not work rather than forcing them to be in the market to maintain a reasonable standard of living, especially if there’s no pressing need for them to be working in the first place. Rather than letting the threat of impoverishment force them into the market, which is a distortion in and of itself, the labor market should need to offer enough to make it worth selling their time rather than being able to invest it in their own projects.

I don’t think you’ve actually seen the inside of a corporate bankruptcy. I have. It’s not fast. It’s not clean. It’s expensive and the professional fees are ruinous. That’s US bankruptcy.

Each European country has its own bankruptcy law. They’re not all that similar, and Greece has a shiny new one (2007) which still needs the kinks worked out.

Since a default would produce a huge wave of bankruptcies (like banks holding large quantities of Greek securities), the courts would be flooded. Then the Greek economy (what’s left of it) would grind to a halt from lack of money.

“Had Greece been allowed to simply default (rather than go through the tortured and lengthy process of technical default through partial “debt forgiveness”), had GM been required to go through normal bankruptcy proceedings, had homeowners not been bailed out by various government programs, etc., the financial crisis would likely be closer to being over than it now is.”

This just isn’t true. A Greek default back then would have destroyed a number of major banks (like Santander). God only knows what would have happened after that. Clearly none of the principals had an urge to find out.

As for GM, who other than the government would have financed them in bankruptcy? Without money to keep operating, they would have been liquidated, their plants sold off and their tooling sold for scrap.

This, of course, would have forced their suppliers (who supply %70 of the value of a car) into bankruptcy. Since these suppliers also supply Ford and Honda…

To think that this would have been a better outcome is insane. Liquidation is the least efficient way to transfer goods, which is why we have chapter 11 in the first place, instead of merely chapter 7.

It seems that there’s evidence that US Policy regarding unions, trade, and the dollar have a large impact on how much the average worker works and how productive. Data has shown that income increases have not corresponded to GDP growth. Plus when workers are more productive they don’t get paid greater either. All of this only happened after the Republican Reagan Revolution started.http://tpmdc.talkingpointsmemo.com/2012/05/40-years-of-workers-left-behind-chart.php?ref=fpnewsfeed
It’s only fair that if workers are more productive then they should earn higher pay. When you produce more while your wages don’t keep up, then there’s something seriously wrong.

Tax rates do not explain this. As far as I can see tax cuts only create deficits. GDP growth was strong in periods before cutting the highest tax rate and GDP was weakest (and unemployment the highest) when tax rates were cut. There seems to be next to no correlation between tax rates and growth unless the rates rise substantially during hard times (austerity in europe is half tax increases).

However, if this blog has taught me anything it’s this: the central bank is way more powerful economically than any other political branch. So, tax rates don’t matter if the central bank is obsessed with a 2% inflation target instead of another measure (like full employment or NGDP targeting).

I buy your point about the labour composition in Europe being very different from the US – though it needs to be backed by evidence, it certainly sounds plausible.

But let’s not talk in absurdities about employment vs. leisure, shall we? The discussion has been about total hours worked per capita in Europe vs US. Unless you are making the claim that the difference comes primarily from employment rates – which I highly doubt you are – then we are talking about leisure of the employed or the general populace, not the unemployed.

Don’t assume you are the only lawyer posting here. I’ve been inside plenty of courtrooms and have worked in business all my life. That sort of self-advertisement is not persuasive in courtrooms or in blogging venues.

Nor does the fact that you say something “just isn’t true” make it so and again you’ve side-stepped the moral hazard issue and gone on to something else. For example,

“As for GM, who other than the government would have financed them in bankruptcy? Without money to keep operating, they would have been liquidated, their plants sold off and their tooling sold for scrap.”

Well, for starters, the unions might have had to pony up rather than secured creditors and the government. This would have helped a re-emerged GM more than anything, but your idea of “debt forgiveness” outside the legal process is one of the best examples of moral hazard (and political corruption) I could come up with.

And, yes, perhaps GM would have been liquidated. So what? Not so long ago David Stockman was interviewed on this point (I believe by Daily Ticker). He astutely and wisely observed that the GM business would have been picked up by other businesses which would not have had any net effect on production or employment in the United States.

Your argument about “debt forgiveness” and banks is also internally incoherent. You’ve argued that it is up to the creditors to work this out and forgive debt outside the normal legal process and at the same time that if they do some will go under. It is inescapable that what you are really arguing for is (more) taxpayer bailouts in order to “clear those drains”.

Don’t assume you are the only lawyer posting here. I’ve been inside plenty of courtrooms and have worked in business all my life. That sort of self-advertisement is not persuasive in courtrooms or in blogging venues.

This just isn’t true. A Greek default back then would have destroyed a number of major banks (like Santander). God only knows what would have happened after that. Clearly none of the principals had an urge to find out.

It’s truly remarkable how successful the program has been of the banks financing the economics profession to convince young impressionable students and now professors and journalists to believe that banks are too big to fail.

I guess if Bill Gates and Steve Jobs could print their own money, people would be fear mongering over the bankruptcies of software and electronics companies and how world war 3 would start if Microsoft ever went bankrupt.

Stop believing the myth. There is nothing wrong with bank bankruptcies. The very word bankrupt is derived from the Italian word for moneylender (euphemistically called “bench”) banca, and the the Latin word for break rupta, for crying out loud.

Are we in such an Orwellian world that “bank breaks” are only good for non-banks?

Milton Friedman was wrong about the Great Depression being caused by monetary deflation. It was primarily caused by a concerted nationwide effort to prevent wage rates from falling. The drop in money supply and spending would have been benign if wage rates were free to fallSTICKY WAGES!

Bad banks that go bankrupt don’t just disappear from existence. They get taken over by better managers. The only people who are benefited from staving off bank bankruptcies are bad bank owners. They gain at the expense of everyone else.

My guess for the reason the Fed bailed out the big US banks is because they didn’t want them bought out by foreigners. The biggest banks are pseudo-political institutions, who have lots of cash to finance politicians. Just imagine Goldman Sachs and JP Morgan becoming Chinese subsidiaries. How much political power would China wield over the US taxpayer, and politicians?

It wasn’t to save the economy. It was to save the politicians and the bank owners. The big banks are now political entities where national security is at stake. They are no longer business institutions. That’s why they’re too big to fail.

And guess what? Since 2008, the too big to fail banks? The ones that all the politicians were yammering about ensuring there is no such thing as too big to fail? Well, they got bigger by getting free money from the Fed, which they used to buy up the smaller banks who did not get any bail out money. The 5 biggest banks went from owning assets that totalled 43% of GDP pre-crisis, to 56% today.

The politicians and the big banks are colluding to loot the country dry. Obama and Romney are the big bank poster boys. They are flushed with big bank cash up the wazoo. Just look at their largest donors. They’re the banker’s politicians. This November is going to be an election between two carbon copies. President Obamney.

Martin: The best argument I saw in this discussion so far. I would also add that according to this report: http://www.bls.gov/fls/intl_gdp_capita_gdp_hour.htm Italians work more than Americans and there seems to be no significant difference between hours worked in countries with very different tax system like Ireland and Sweden.

Mike: Consumption tax and “demand”. This seems to be a very weird argument, because I thought that every economist agrees that in the long run what actually matters is aggregate supply. So unless you have any theory how change from income taxes to consumption taxes negatively affects incentives to produce, your argument is not valid.

What you seem to assume is that shift from income taxes to consumption taxes MUST automatically mean increase in the marginal tax rates for the poor. From here you can actually use Scott’s argument that higher taxes mean lower incentive to work which causes lower aggregate supply and poorer society. That is the only story that makes macro-economic long-term sense.

The point is, that inequality does not matter for macro purposes. I can imagine world where masses of poor work 16 hours a day for leaf of bread who produce luxury yachts and space hotels (and appropriate capital goods to maintain this production structure) for top 0,001%. Such world could have full employment and could be considered as being on potential output.

The other point (for Scott) is that I can imagine that such world could exist even in absence of taxes, regulation and that it could be an outcome of free markets. All you need to assume is what Matt Ronglie said – that poor masses simply do not provide substitutable labor inputs. This may be the case if somewhere in the future only fraction of population will be able to use some new advanced technology.

This is why I think that this whole discussion may be interesting, but it may be beside the point. Because:

1. No one knows what the tax is. For instance in Germany people pay health insurance as part of social security. It is tax. In USA people pay health insurance in a semi-private highly regulated models (no-tax) system. In both systems it is large part of the population that pays relatively similar shares from their income (salary) for a service that seems to have similar results for majority of population. How this (for me technical difference) can cause difference in incentives is mystery. Take other example – compare system of state controlled fully of virtual pension accounts in Sweden (tax) with private pension schemes. Both provide similar service, but they affect in a very different way the tax-to-GDP ratio. It is an overall effectiveness of these to the other can have much higher impact on general well-being of the respective societies.

2. Unions, redistribution etc. There is one side of the story that these regulations make markets less effective. The other part of the story is, if giving free reign to markets actually fulfills the goal of economy since Adam Smith – that nations – or more specifically that masses of people that are actually those nations live better lives. Unions and redistribution can play a large part in the political process. They may serve as balance for other powerful players to capture the market. Even if these players want only to unleash the full power of the free market in a way that is not consistent with wel- being of majority.

Mike Sax, There are no marginal tax rates on consumption? I don’t even know what that means. And recall that a labor tax is identical to a consumption tax, in terms of long run incidence.

Very little consumption is done by the poor as a share of GDP, which in any case is irrelevant as the Keynesian spending model based on MPCs is completely irrelevant in a world where central banks target inflation.

KRG, You said;

“Indeed- the question is how to bring that 9% down; freely choosing how much to work should involve allowing some portion of that 9% to freely choose to not work rather than forcing them to be in the market to maintain a reasonable standard of living,”

Is this a joke? Are you claiming that those who don’t want to work should be given salaries anyway? I feel I have to work or else I won’t have money to pay my bills. I don’t feel there is any unreasonable burden being placed on me. Have we reached the point where we think people shouldn’t have to work in order to pay the bills, that they should be able to free-load on others? I thought that even America’s liberals abandoned that view long ago. Even the Swedes abandoned that view.

Eric, Many of those trends started before Reagan (especially falling union share) and have little to do with Reagan.

Ritwik, What absurdity? The natural rate of unemployment is much higher in Europe than the US, partly due to tax differences. (Note, more generous unemployment insurance is effectively a tax on labor.)

JV, You make a good point about the complexity of the tax issue–you can’t simply look a the overall tax burden. On the other hand insurance and tax financing are not identical, for instance the Singapore forced savings approach to health care and pensions is far better for incentives that the Western tax approach to funding those activities. Hence much higher hours worked.

I think it’s also essential to focus on one issue at a time. It may be that unions and high taxes are great policy ideas. But the question I am examining is whether they reduce hours worked. Sometimes I feel liberals are ambivalent about whether to defend the European system by denying it reduces hours worked, or by saying it does, but other good things are more important. Both defenses are plausible, but it’s important to focus on one issue at a time.

What is the natural rate of unemployment in Europe vs US? 8% vs 6%? or 10% vs 6%? 2%-3% of the employment seeking workforce, which is 50%-60% of the populace. Overall 1%-2% of the population.

We are talking about hours worked per capita in Europe being of the order of 75% to 80% of the US. That’s a 20% to 25% gap. You want to explain that in terms of a reduced workforce of 1% to 2%? Sure. Be your own guest.

Here is another report from OECD: http://economix.blogs.nytimes.com/2011/04/12/mexicans-work-the-longest-hours/ Honestly, I do not think that taxes vs hours worked seems as convincing. However the last link introduced another interesting notion. It counts commute time to work into overall hours worked. So this is just another piece that shows how complex this topic really is. It may very well be so that a country with better/worse transportation system will have completely different results that will not fit any reports based on pure tax data.

Ritwik, I don’t accept either your numbers or your characterization of my argument (which you clearly distorted.) I never claimed that unemployment was the sole explanation for the difference in hours worked. And as you must know the unemployment rate doesn’t capture differences in labor force participation

JV, Never trust that sort of data, taxes are actually extremely high in the Gulf States, which is why work effort is very low. It fits my hypothesis perfectly. Those numbers ignore the tax on oil.

The past is a foreign country because generations rise and fall, Herr Professor. Hence why time remains the best way to explain work effort variation. Hence why your trusty ‘culture’ kludge is useless in addition to being a dog whistle.

As to the cross-sectional variation, As JLS’s comment attests, what French people expect and value is not the same thing as what Americans expect and value, and pretty far from it. Anyone who thinks the 5 week vacation is a tax scheme does not know as many Continental Europeans as I do, not least of the younger variety. This different perspective is evident from everything they do, frankly. Can you imagine, for example, what we’d have to pay French people to forgo their lunch breaks?

If you were trying to argue that high taxes enable a vast welfare state that disencourages work, you’d get no argument from me, (I have heard this as well from French nationals), but the idea that tax rates play a meaningful role is just not tenable. Piketty was right to be dismissive of this ostensible ‘evidence’. If Prescott wanted to be taken seriously, he should demonstrate a modicum of interest in these profoundly confounding factors.

Majorajam. I usually find the most obnoxious commenters are also the most uninformed. You are no exception. You said:

“The past is a foreign country because generations rise and fall, Herr Professor. Hence why time remains the best way to explain work effort variation.”

Just the opposite. Time series data is almost useless because many of the effects are extremely long run, perhaps several decades. Time series analysis is useless in that case. In any case, if the past is another country, doesn’t that discredit time series analysis?

But this one really made me smile:

“If you were trying to argue that high taxes enable a vast welfare state that disencourages work, you’d get no argument from me, (I have heard this as well from French nationals), but the idea that tax rates play a meaningful role is just not tenable.”

Yes, that is exactly what I am claiming. You obviously have never studied public finance. When an economist talks about “taxes” he is including the implicitly high MTRs created by welfare programs. Indeed that is by far the most important reason why high taxes reduce work effort.

Your observations about French culture were charming, but I’m afraid useless for this argument. When economic incentives change (for instance making divorce more desirable), the culture will eventually change in such a way as to validate the change. Over time people will forget what what caused the change, and simply attribute it to culture.

And how come you weren’t in the comment section a couple weeks back when I did a post arguing that there was no such thing as “superior cultures,” and all the commenters seemed to think I was nuts. I thought you’d be in there defending me. After all, claims of cultural superiority are just disguised racism in your view, aren’t they? Oh wait, now it’s you claiming the French have a lazy culture. Nevermind.

“When economic incentives change (for instance making divorce more desirable), the culture will eventually change in such a way as to validate the change. Over time people will forget what what caused the change, and simply attribute it to culture.”

Abstract:
“Aggregate labor supply is higher in America than in Europe, and there is also substantial variation within Europe. Using micro data from the US and eight European countries, we document that the difference between the US and Europe is mainly driven by the labor supply of women. European women work less than American women, whether it is single women, married women, or women with and without children. Using a larger number of countries, we also document that there is a strong correlation between divorce rates and female labor supply across countries and across time. Recent literature argues that differences in labor supply between the US and Europe can largely be explained by differences in tax rates. We use tax data from the OECD to develop tax schedules for a sample of 16 countries. The empirical correlation between hours worked and different measures of tax levels and progressivity is negative, however, weak. To account for cross-country differences in labor supply, we develop a life-cycle model with heterogeneous agents, marriage, and divorce. There are three types of households; single males, single females and married households. Divorces and marriages occur stochastically. The main channel through which individual divorce and singlehood rates impact labor supply is by reducing the implicit insurance of marriage, and thereby providing incentives for individuals to invest in experience / human capital accumulation. We calibrate our model to US data and study how labor supply in the US changes as we introduce a German tax system, and as we replace the US divorce / marriage rates with their Spanish equivalents. We find that introducing a German tax policy in the US reduces labor supply by between 2% and 11% depending on the use of the increased tax revenues. This decrease in hours worked corresponds to between 7% and 39% of the difference between the two countries in the data. Changing the US probabilities of marriage and divorce to their Spanish equivalents leads to a 15% drop in female labor supply, or about 33% of the difference between the two countries in the data, while there is only a 1% drop in male labor supply.”

Mark, A couple points. First, when I talk about “taxes” I obviously mean taxes and benefits, with the latter being more important. Second, our upper middle class married women tend to work quite a bit, so I have a hard time understanding how divorce could be driving this result. But those are initial impressions, obviously I haven’t had time to give it careful consideration.

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Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. Read more...

Bio

My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun research on the relationship between cultural values and neoliberal reforms, when I got pulled back into monetary economics by the current crisis.